Eurozone leaders agreed to transfer bank supervision to the ECB with the detail yet to be fleshed out. It is widely acknowledged that giving the ECB two tasks creates a conflict of interest. This column argues that the two functions must be separated by setting up a Supervisory Board, operating independently within the ECB, and by granting the new supervisors a solvency instrument that is independent of the interest rate.

Assigning the task of banking supervision to the ECB raises questions regarding the relationship between its primary mandate, monetary policy, and the newly attributed supervisory powers. A serious concern is that monetary policy runs the risk of no longer being independent. Therefore, it has to be ensured that the functions of supervision and monetary policy are clearly separated and independent from political control. However, monetary and financial stability are very much related and mutually reinforce each other, especially in the longer term. Any new institutional design should be able to reconcile both objectives in the end.

Do we need to separate monetary policy from supervision?

Centralising supervision in Europe is absolutely necessary to safeguard financial stability. However, there may also be dangers to price stability and the ECB’s credibility as an inflation fighter. The setup of the European Systemic Risk Board was a first step in separating monetary from macroprudential policy.

With the advent of microprudential supervision as a new task for the ECB, new problems may arise. The most important is:

The possibility of conflicts of interest, or the trade-off between monetary and financial stability when the ECB has only one instrument: the interest rate.

This can lead to a time inconsistency problem (Ueda and Valencia 2012). While ex ante a central bank will set the correct interest rate, ex post it has an incentive to keep the interest rate low to protect the financial sector (leading to excessive inflation). Combining monetary and microprudential policy can lead to trade-offs as well.

Banks are constrained in their lending by capital requirements, which can hinder the conduct of monetary policy (Cecchetti and Li 2008); regulatory authorities thus have an incentive to lower capital requirements to facilitate monetary transmission (Cohen-Cole and Martinez-Garcia 2008).

This means a situation may arise in which the ECB exercises forbearance.

To reach its financial stability goals, it may need to increase mandatory capital buffers. However, as this will impair the monetary transmission process the ECB may decide not to intervene. The current situation in sovereign debt markets complicates the process, as balance sheet policies blur the lines between monetary policy, fiscal policy and financial stability (Borio 2011). When the ECB buys government bonds it buys time for structural change, but endogenises the involved governments’ fiscal policies.

Another concern is that the quest for financial stability and the accompanying measures might be inflationary.

Figure 1 shows that inflation has been above the target of 2% for two years consecutively. The two histograms in Figure 2 show inflation expectations as forecast by the ECB’s Survey of Professional Forecasters; inflation expectations are around 2% for 2013, but above 2% for the longer term (2017). This expectation may even increase, as the ECB has made its balance sheet endogenous by its massive long-term refinancing operations. With the on-going sovereign debt crisis it is difficult for the ECB to determine the right exit strategy, which can lead to liquidity addicted banks and continually unsustainable government policies.

How should the separation of monetary policy and supervision be achieved?

To begin with, the European Systemic Risk Board, which tackles macroprudential policy, should remain operationally independent from the ECB. It must be able to issue warnings and recommendations without the risk of political interference. This protection makes sure that the Board is able to “take the punchbowl away as the party gets going” and creates a clear mandate of crisis prevention (Borio 2011).

The ECB’s mandate will be augmented with microprudential crisis prevention. However, to perform this task the ECB has to dispose over a new instrument; in particular, this instrument should influence the solvency position of individual financial institutions. The early intervention powers the ECB will receive can fulfil this criterion, as long as the ECB can use them without political interference. Additionally, they have to be completely independent from the policy rate (Tinbergen rule), requiring significant institutional change.

This means that financial supervision should be separated from the decisions about monetary policy in the Governing Council. This may prove to be difficult, as the Maastricht Treaty requires the Council to be ultimately responsible for all decisions made under the ECB roof (including the European Systemic Risk Board). Nevertheless, there are solutions that can fulfil the requirement of independent decisions. These are depicted in Figure 3, where the parts in red represent new elements in the mandate of the ECB.

Figure 3 Supervision under the ECB’s roof

Source: Author’s elaboration; the parts in red indicate the new parts in the ECB’s mandate.

One solution proposed by the Commission (and others) is to set up a separate Supervisory Board responsible for micro-prudential supervision. This Board will consists of members from the ECB and national supervisors, who jointly (and independent from monetary policy) make decisions about microprudential supervision. Its chair and vice-chair will be elected from the ECB Governing Council and will have a non-renewable term of five years. Another solution may be to make use of the accompanying persons, or alternates, to the national central bank governors in the Governing Council. At the moment these are often monetary experts that either join or replace the governors of their national central banks in Governing Council meetings. However, when these meetings concern supervisory policy they can be replaced by supervision experts that are made explicitly responsible for micro-prudential supervision. The advantage of this setup is that no extra layer has to be created in the ECB’s governance structure; a Supervisory Board will require this. On the other hand, a Supervisory Board may be more independent from monetary policy.

The solutions above also share some features. For instance, it is sensible to make a member of the Executive Board responsible for supervision. This can be the vice-president or perhaps a newly appointed board member with specific supervisory expertise. Furthermore, both supervisory setups will dispose over the same instrument, namely early intervention.

Institutional separation is no ultimate solution

There are no Chinese walls in the head of ECB President Draghi, who will be ultimately responsible for monetary policy as well as banking supervision. In the end, he will always have to opt for either price stability or financial stability if they clash. It is, therefore, not possible to make monetary and supervisory policy completely independent from each other in the long run. However, it is possible to separate decision making for both mandates, especially when the ECB has two orthogonal instruments at its disposal.

Furthermore, both supervision and monetary policy should be independent from political control. For monetary policy this independence has long been established; supervision should have the same status. Ex post, the ECB should be accountable to the European Parliament for both monetary and supervisory policy (Masciandaro et al. 2012). This independence from political control is necessary to avoid regulatory forbearance and diminish the chances of regulatory capture. For politicians, this may be tough to swallow as they are very reluctant to give up control over supervision, especially intervention powers.1 Freeing supervision from political influence may prove to be even more important than independence between monetary and supervisory policy.

Conclusion

As the ECB will become responsible for micr-prudential supervision, we have to carefully assess the consequences for its primary mandate: price stability. Conceptually, both mandates are mutual prerequisites. Price stability is necessary for financial stability (ECB 2011) and a stable financial system is required for proper transmission of monetary policy. However, conflicts of interest may arise when the ECB is both bank supervisor and monetary policymaker.

To circumvent these we need to clearly separate the two functions. This can be done by setting up a Supervisory Board, operating independently within the ECB, or by appointing national supervisors as alternates to national central bank governors in the Council. In both cases, a member of the ECB’s Executive Board should be responsible for supervision. Also, the new supervisors should dispose over a solvency instrument that is independent of the interest rate and allows for early intervention in potential problem banks.

Note that this is not the ultimate solution to the problem, as ECB President Draghi will ultimately be responsible for both monetary policy and supervision. Separating both functions is, however, a step in the right direction. In the end, both supervision and monetary policy should be independent from each other as well as from politics.

References

Borio, Claudio (2011), "Central banking post-crisis: What compass for uncharted waters?", BIS Working Paper No 353, Bank for International Settlements.